Reconsidering Use of 401(k) Funds for Emergencies

Question:

Current tax rules governing 401(k) plans allow workers to distribute funds for hardship expenses prior to age 59 ½. The distributed funds are fully taxed at the ordinary income tax rate and subject to a 10 percent penalty.

Should rules governing 401(k) plans be changed to allow for the allocation of limited 401(k) funds to an emergency fund and new restrictions on the bulk of 401(k) contributions prior to age 59 ½?

In many states, people with assets in 401(k) plans and IRAs are not eligible for government benefits including food stamps.

Should these rules be altered so that funds not available for immediate disbursement do not impact eligibility for government benefits?

Specifics of the proposed rule changes are as follows:

Workers may allocate 20 percent of their 401(k) contribution or IRA contribution to an emergency fund.

Funds placed in the emergency fund could be distributed for emergency expenses without being subjected to income tax or a tax penalty.

Disbursements from all 401(k) or IRA contributions not in the emergency fund prior to the age of 59 ½ would be prohibited.

Future 401(k) loans would be eliminated.

Funds in 401(k) plans and IRAS that were not available for immediate disbursement would not be counted toward Medicaid or food stamp eligibility.

Background: Many workers, especially those entering the workforce, must choose between establishing an emergency fund or saving for retirement through a 401(k) plan. The financial advantages associated with 401(k) plans, both in the form of an employer match and tax savings can be substantial. However, many workers have insufficient funds to pay rent, health bills and outstanding loans. Some workers with limited liquidity choose to create a retirement fund and delay saving for retirement.

The IRS allows workers to withdraw money from their 401(k) plan prior to retirement but the practice is discouraged through the imposition of a 10 percent penalty.

Around 87 percent of 401(k) plans allow workers to borrow funds form their 401(k) plan. Around 18 percent of workers in plans allowing 401(k) loans had loans outstanding. The average outstanding loan balance for 401(k) loans at the end of 2015 was a bit lower than $8,000.

These rules discourage low-income workers with variable income from making 401(k) contributions.

Discussion

Contributions to 401(k) plans, unlike contributions to traditional pensions or Social Security, are voluntary. Some people with limited liquid assets and high debt levels are reluctant to tie up funds in a retirement account. The early disbursement option (albeit with taxes and penalty) and the loan option can encourage some people to contribute to their 401(k) plan.

Individuals who disburse funds from 401(k) plans prior to age 59 ½ may have insufficient resources in retirement. Moreover, individuals who take disbursements prior to age 59 ½ and pay taxes and a penalty may become worse off than individuals who never contributed to their 401(k) plan.

The emergency fund feature of the new 401(k) would provide substantial incentives for people with limited liquidity and large debts to make 401(k) contributions. However, the prohibition against early disbursements from the bulk of 401(k) contributions could reduce the number of people with insufficient funds in retirement.

Under the new rules, 401(k) or IRA funds not available for immediate disbursement would not affect eligibility for any government benefits. This change would encourage low-income people to make additional contributions to 401(K) plans and IRAs.